8 Rules for 8% Income Investing in CEFs

Brett Owens, Chief Investment Strategist
Updated: December 21, 2016

The 10-year’s yield up to 2.6%? Big deal – you and I still aren’t retiring off it!

Hence the appeal of closed-end funds (CEFs), which often pay 8% or better. That’s the difference between a paltry minimum-wage income of $26,000 on a million bucks in capital, or a respectable $80,000 annually.

And if you’re smart about your CEF purchases, you can even buy them at discounts and snare some price upside to boot!

Unfortunately this rising rate environment has income seekers scared of CEFs. Many of our Contrarian Income Report subscribers are writing in to ask if they should bail on our high paying vehicles. The financial media is in their heads, and they’re concerned that their funds are suddenly going to drop in price.

Please, don’t toss yourself into poverty by following this misguided herd!

With the markets in flux, we should review the principles of successful CEF investing. They are more nuanced than classic stock picking, because we’re analyzing managers, strategies and holdings versus simple businesses models. After all, for lazy investors, it’s easier to count on dividends via AT&T’s (T) subscriptions than it is to determine how much China exposure the Aberdeen Asia-Pacific Income Fund (FAX) has!

(The answer? Almost none. But that bit of extra bit of research will lead you to a secure 8.9% yield, versus just 4.6% for AT&T!)

CEF Rule #1: Be Careful With Price Charts

PIMCO’s Dynamic Income Fund (PDI) has been a great performer since its inception almost five years ago – but you’d never know it from its price chart:

Looks Like a Dog…

… Until You Add the Payouts Back!

Make sure the chart you’re reading includes dividends paid (so that it reflects total returns).

CEF Rule #2: Demand Alpha

Past performance can be an educational indicator about the quality of the management team and its strategy. PDI has had the benefit of the brightest bond minds on the planet calling the shots (from “Bond King” Bill Gross to current superstar Dan Ivascyn) and it delivered 108% total returns over the last five years. With most of these coming in the form of cash payouts.

Meanwhile BlackRock’s International Growth and Income Trust (BGY) is a disappointment with no excuse. The fund supposedly writes covered call options on its positions to boost income. This strategy should limit upside but provide stable, steady returns.

However over the last three years, while the markets gently floated higher, BGY managed to lose 7.6%. Don’t be fooled by the siren song of its fat 8.4% current yield. Which brings me to our next point…

CEF Rule #3: Check Every Yield’s Back Story

Some funds pay big distributions that look great – but they’re not sustainable. However they continue to attract new (sucker) investors because they are able to fund their payouts – they just happen to shed their net asset value (NAV) at a similar pace!

For example, here are three more dogs that have mostly grinded sideways over the last four years (even when accounting for dividends paid):

Big Yields, But Lackluster Returns

CEF Rule #4: Know What’s Funding Your Distributions

A closed-end fund can pay you from some combination of:

Investment income,

Capital gains, and/or

Return of capital.

Of the three, investment income is preferable because it’s usually the most reliable. Many CEFs pay monthly distributions, so it’s best if they match up their payouts with steady income streams themselves.

Capital gains from rising bond or stock prices can further boost distributions. But they are at risk of disappearing if the markets turn unfavorably, as we just saw with muni bonds.

Finally everyone assumes return of capital is bad, because it’s simply shipping your money back to you. But if the fund trades at a sizeable discount, this can actually be a savvy way to kick start the closing of a discount window. More on this shortly.

CEF Rule #5: Don’t Be Cheap About Fees

Most investors are conditioned by their experience with mutual funds and ETFs to search out the lowest fees, almost to a fault. This makes sense for investment vehicles that are roughly going to perform in-line with the broader market. Lowering your costs minimizes drag.

Closed-ends are a different investment animal, though. On the whole, there are many more dogs than gems. It’s an absolute necessity to find a great manager with a solid track record. Great managers tend to be expensive, of course – but they’re well worth it.

The stated yields you see quoted, by the way, are always net of fees. Your account will never be debited for the fees from any fund you own. They are simply paid by the fund itself from its NAV.

CEF Rule #6: Ignore Short-Term Interest Rates

Many funds are selling at bargain prices today thanks to the headline worry that higher rates hurt CEFs. But that’s just not true.

Libor is tied closely to the Fed funds rate. And the last time the Fed hiked its significantly, CEFs did just fine.

In June 2004, Fed chair Alan Greenspan began boosting rates from then-historic lows. Over a two-year period, he increased the federal funds rate from 1% to 5.25%. An earthquake.

Mutual funds issue more shares whenever they want. But closed-ends have a fixed share count, with their funds trading like stocks. As a result, from time-to-time a fund will fall out-of-favor and find its shares trading at a discount to its NAV.

This is basically “free money” because these underlying assets are constantly marked to market. If a fund trades at a 10% discount, management could theoretically liquidate the fund and cash out everyone at $1.10 on the dollar immediately. Or it can buy back its own shares to close the discount window (and boost the share price).

It’s rare to see any fixed income manager put his or her own money on the line at all, unfortunately. According to Barron’s, out of 558 closed-end funds, nearly half (269) have no insider ownership whatsoever. And only 70 have insider ownership above $500,000.

Well that’s not exactly right. Their principal is more than 100% intact thanks to price gains like these! Which means principal is actually 110% intact after year 1, and so on.

To do this, I seek out closed-end funds that:

Pay 8% or better…

Have well funded distributions…

Trade at meaningful discounts to their NAV…

And know how to make their shareholders money.

And I talk to management, because online research isn’t enough. I also track insider buying to make sure these guys have real skin in the game.

Today I like three “blue chip” closed-end funds as best income buys. And wait ‘til you see their yields! These “slam dunk” income plays pay 8.2%, 9.9% and even 10.1% dividends.

Plus, they trade at 10-15% discounts to their net asset value (NAV) today. Which means they’re perfect for your retirement portfolio because your downside risk is minimal. Even if the market takes a tumble, these top-notch funds will simply trade flat… and we’ll still collect those fat dividends!